When it comes to funding a small business, there are two basic options: debt or equity financing.
Each has its advantages and drawbacks, so it’s important to know a bit about both so you can make the best decision for financing your business.
Debt financing involves borrowing money, typically in the form of a loan from a bank or other financial institution or from commercial finance companies, to fund your business.
Getting a business loan generally requires good credit and solid financials, as well as collateral for larger loans.
Many small business owners are afraid to take on debt because they fear they may not have the cash flow to repay the debt (plus interest) in a timely fashion.
Others may be concerned that they don’t have the credit-worthiness to get a bank loan, and so don’t want to even bother applying.
But debt financing has some definite advantages that make it an option worth considering for any small business owner.
First and foremost, unlike with equity financing, debt financing allows you to retain control of your business, as ownership stays fully in your hands.
You may have to back up a loan with collateral, so if you default you may lose certain tangible assets, but you won’t lose creative and strategic control of your business.
In addition, taking on debt can build your business credit, which is good for future borrowing and for insurance rates.
It’s also worth bearing in mind that interest paid on loans is tax deductible, softening the blow of repayment somewhat.
Equity financing involves bringing in investors or partners who provide capital in exchange for a share of ownership of the business.
These investors or partners generally invest because they expect to make a profit when the business becomes successful.
Unlike a loan, if you don’t make a profit, you usually aren’t required to pay them back. The absence of monthly loan payments can free up significant working capital for the business.
Many small business owners also are drawn to equity financing because, while investors or partners will only provide equity if they have faith in the earning power of your business, you don’t necessarily need the pristine financial history that is required for a loan.
This can be a crucial point for many small business owners, especially for those just starting a business without the two or three years of financials most banks look at.
The cost of these benefits is that you no longer retain sole control of your business.
This means that not only will your investors be entitled to a share of profits, but they also have a say in the running of your business and the direction it’s headed.
This may not seem like a problem at the beginning when you need cash, but can sometimes lead to conflict further down the road.
On the other hand, a strong, smart partner may be an asset to your business; especially if you find someone who is a good compliment to yourself.
If you’re the creative, visionary type, you may benefit from the balancing influence of a partner who is grounded and pennywise.
The Bottom Line
Because each type of financing has its own appeal, businesses often take advantage of both debt and equity financing, utilizing each to its best advantage.
Look at the benefits of each to see which may most help your business, and compare typical debt-to-equity ratios for other businesses in your industry when deciding what type of financing to seek.
Ked Harley is a writer and researcher for Biz2Credit Business Loans, a leading credit marketplace connecting small- and medium-sized businesses with small business loans, service providers, and complementary business tools. She is also a self-confessed coffee addict working out of New York City. Her interests include business and finance, world news, food, and travel, and she enjoys yoga and running in the park. Follow Biz2Credit on Twitter for small business news and updates.